Uncertainty and reflexivity — two things missing from Krugman’s economics

18 September, 2014 at 09:36 | Posted in Theory of Science & Methodology | 3 Comments

One thing that’s missing from Krugman’s treatment of useful economics is the explicit recognition of what Keynes and before him Frank Knight, emphasized: the persistent presence of enormous uncertainty in the economy. Most people most of the time don’t just face quantifiable risks, to be tamed by statistics and probabilistic reasoning. We have to take decisions in the prospect of events–big and small–we can’t predict even with probabilities.uncertainty Keynes famously argued that classical economics had no role for money just because it didn’t allow for uncertainty. Knight similarly noted that it made no room for the entrepreneur owing to the same reason. That to this day standard economic theory continues to rules out money and excludes entrepreneurs may strike the noneconomist as odd to say the least. But there it is. Why is uncertainty so important? Because the more of it there is in the economy the less scope for successful maximizing and the more unstable are the equilibria the economy exhibits, if it exhibits any at all. Uncertainty is just what the New Classical neglected when they endorsed the efficient market hypothesis and the Black-Scholes formulae for pumping returns out of well-behaved risks.

If uncertainty is an ever present, pervasive feature of the economy, then we can be confident, along with Krugman, that New Classical models wont be useful over the long haul. Even if people are perfectly rational too many uncertain, “exogenous” events will divert each new equilibrium path before it can even get started.

There is a second feature of the economy that Krugman’s useful economics needs to reckon with, one that Keynes and after him George Soros, emphasized. Along with uncertainty, the economy exhibits pervasive reflexivity: expectations about the economic future tend to actually shift that future. This will be true whether those expectations are those of speculators, regulators, even garden-variety consumers and producers. Reflexiveness is everywhere in the economy, though it is only easily detectable when it goes to extremes, as in bubbles and busts, or regulatory capture …

When combined uncertainty and reflexivity greatly limit the power of maximizing and equilibrium to do useful economics … Between them, they make the economy a moving target for the economist. Models get into people’s heads and change their behavior, usually in ways that undermine the model’s usefulness to predict.

Which models do this and how they work is not a matter of quantifiable risk, but radical uncertainty …

Between them reflexivity and uncertainty make economics into a retrospective, historical science, one whose models—simple or complex—are continually made obsolete by events, and so cannot be improved in the direction of greater predictive power, even by more complication. The way expectations reflexively drive future economic events, and are driven by past ones, is constantly being changed by the intervention of unexpected, uncertain, exogenous ones.

Alex Rosenberg

[h/t Jan Milch]

Revealed preference theory — redundant fuss about almost nothing

17 September, 2014 at 20:17 | Posted in Economics | Leave a comment

awongTwenty years ago, yours truly had an article in History of Political Economy (no. 25, 1993) on revealed preference theory.

Paul Samuelson wrote a kind letter and informed me that he was the one who had recommended it for publication. But although he liked a lot in it, he also wrote a comment — published in the same volume of HOPE — saying:

Between 1938 and 1947, and since then as Pålsson Syll points out, I have been scrupulously careful not to claim for revealed preference theory novelties and advantages it does not merit. But Pålsson Syll’s readers must not believe that it was all redundant fuss about not very much.

I came to think about this little episode when, prepairing for a lecture on the law of demand, I re-read Stanley Wong’s  minor classic on Samuelson’s revealed preference theory. And I have to admit I still find the theory much fuss about not very much.
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Krugman and Mankiw on loanable funds — so wrong, so wrong

16 September, 2014 at 09:50 | Posted in Economics | 19 Comments

Earlier this autumn yours truly was invited to participate in the New York Rethinking Economics conference. A busy schedule didn’t allow me to “go over there.” Fortunately some of the debates and presentations have been made available on the web, as for example here. Listening a couple of minutes into that video one can hear Paul Krugman strongly defending the loanable funds theory.

Unfortunately this is not an exception among “New Keynesian” economists.

Neglecting anything resembling a real-world finance system, Greg Mankiw — in the 8th edition of his intermediate textbook Macroeconomics — has appended a new chapter to the other nineteen chapters where finance more or less is equated to the neoclassical thought-construction of a “market for loanable funds.”

On the subject of financial crises he admits that

perhaps we should view speculative excess and its ramifications as an inherent feature of market economies … but preventing them entirely may be too much to ask given our current knowledge.

This is of course self-evident for all of us who understand that both ontologically and epistemologically founded uncertainty makes any such hopes totally unfounded. But it’s rather odd to read this in a book that bases its models on assumptions of rational expectations, representative actors and dynamically stochastic general equilibrium – assumptions that convey the view that markets – give or take a few rigidities and menu costs – are efficient! For being one of many neoclassical economists so proud of their (unreal, yes, but) consistent models, Mankiw here certainly is flagrantly inconsistent!

And as if being afraid that all the talk of financial crises might weaken the student’s faith in the financial system, Mankiw, in his concluding remarks, has to add a more Panglossian warning that we

should not lose sight of the great benefits that the system brings … By bringing together those who want to save and those who want to invest, the financial system promotes economic growth and overall prosperity


Finance has its own dimension, and if taken seriously, its effect on an analysis must modify the whole theoretical system and not just be added as an unsystematic appendage. Finance is fundamental to our understanding of modern economies, and acting like the baker’s apprentice who, having forgotten to add yeast to the dough, throws it into the oven afterwards, simply isn’t enough.

I may be too bold, but I’m willing to take the risk, and so recommend Krugman and Mankiw to make the following addition to their reading lists …

Fallacy 2

Urging or providing incentives for individuals to try to save more is said to stimulate investment and economic growth.

This seems to derive from an assumption of an unchanged aggregate output so that what is not used for consumption will necessarily and automatically be devoted to capital formation.

Again, actually the exact reverse is true. In a money economy, for most individuals a decision to try to save more means a decision to spend less; less spending by a saver means less income and less saving for the vendors and producers, and aggregate saving is not increased, but diminished as vendors in turn reduce their purchases, national income is reduced and with it national saving. A given individual may indeed succeed in increasing his own saving, but only at the expense of reducing the income and saving of others by even more.

Where the saving consists of reduced spending on nonstorable services, such as a haircut, the effect on the vendor’s income and saving is immediate and obvious. Where a storable commodity is involved, there may be an immediate temporary investment in inventory, but this will soon disappear as the vendor cuts back on orders from his suppliers to return the inventory to a normal level, eventually leading to a cutback of production, employment, and income.

Saving does not create “loanable funds” out of thin air. There is no presumption that the additional bank balance of the saver will increase the ability of his bank to extend credit by more than the credit supplying ability of the vendor’s bank will be reduced. If anything, the vendor is more likely to be active in equities markets or to use credit enhanced by the sale to invest in his business, than a saver responding to inducements such as IRA’s, exemption or deferral of taxes on pension fund accruals, and the like, so that the net effect of the saving inducement is to reduce the overall extension of bank loans. Attempted saving, with corresponding reduction in spending, does nothing to enhance the willingness of banks and other lenders to finance adequately promising investment projects. With unemployed resources available, saving is neither a prerequisite nor a stimulus to, but a consequence of capital formation, as the income generated by capital formation provides a source of additional savings.

Fallacy 3

Government borrowing is supposed to “crowd out” private investment.

The current reality is that on the contrary, the expenditure of the borrowed funds (unlike the expenditure of tax revenues) will generate added disposable income, enhance the demand for the products of private industry, and make private investment more profitable. As long as there are plenty of idle resources lying around, and monetary authorities behave sensibly, (instead of trying to counter the supposedly inflationary effect of the deficit) those with a prospect for profitable investment can be enabled to obtain financing. Under these circumstances, each additional dollar of deficit will in the medium long run induce two or more additional dollars of private investment. The capital created is an increment to someone’s wealth and ipso facto someone’s saving. “Supply creates its own demand” fails as soon as some of the income generated by the supply is saved, but investment does create its own saving, and more. Any crowding out that may occur is the result, not of underlying economic reality, but of inappropriate restrictive reactions on the part of a monetary authority in response to the deficit.

William Vickrey Fifteen Fatal Fallacies of Financial Fundamentalism

Rethinking methodology and theory in economics

16 September, 2014 at 07:59 | Posted in Theory of Science & Methodology | Leave a comment


Socialdemokratins historiska svek — en dag efter valet!

15 September, 2014 at 21:28 | Posted in Politics & Society | 3 Comments

Wikip-facepalmMindre än ett dygn efter att riksdagsvalet 2014 är klart meddelar Stefan Löfven kategoriskt att han inte kan tänka sig att ingå ett regeringssamarbete med Jonas Sjöstedt och vänsterpartiet. Däremot håller han dörren öppen för ett eventuellt samarbete med Annie Lööf och hennes högerextrema centerparti.

Man tror knappt det är sant. Ska detta kallas ett arbetarparti? Har man sovit det senaste decenniet och inte noterat att en nyliberal Stureplansmaffia tagit över det en gång så stolta parti som leddes av Gunnar Hedlund och Torbjörn Fälldin? Man tar sig för pannan!

IS-LMism and unlimited ‘ceteris paribus’ alibi

15 September, 2014 at 15:10 | Posted in Economics | 5 Comments

When applying deductivist thinking to economics, neoclassical economists usually set up “as if” models based on a set of tight axiomatic assumptions from which consistent and precise inferences are made. The beauty of this procedure is of course that if the axiomatic premises are true, the conclusions necessarily follow. The snag is that if the models are to be relevant, we also have to argue that their precision and rigour still holds when they are applied to real-world situations. They often don’t. When addressing real economies, the idealizations necessary for the deductivist machinery to work — as e. g. IS-LM and DSGE models — simply don’t hold.

If the real world is fuzzy, vague and indeterminate, then why should our models build upon a desire to describe it as precise and predictable? The logic of idealization is a marvellous tool in mathematics and axiomatic-deductivist systems, but a poor guide for action in real-world systems, in which concepts and entities are without clear boundaries and continually interact and overlap.

Or as Hans Albert has it on the neoclassical style of thought:

In everyday situations, if, in answer to an inquiry about the weather forecast, one is told that the weather will remain the same as long as it does not change, then one does not normally go away with the impression of having been particularly well informed, although it cannot be denied that the answer refers to an interesting aspect of reality, and, beyond that, it is undoubtedly true …

hansalbertWe are not normally interested merely in the truth of a statement, nor merely in its relation to reality; we are fundamentally interested in what it says, that is, in the information that it contains …

The neoclassical style of thought – with its emphasis on thought experiments, reflection on the basis of illustrative examples and logically possible extreme cases, its use of model construction as the basis of plausible assumptions, as well as its tendency to decrease the level of abstraction, and similar procedures – appears to have had such a strong influence on economic methodology that even theoreticians who strongly value experience can only free themselves from this methodology with difficulty …

Clearly, it is possible to interpret the ‘presuppositions’ of a theoretical system … not as hypotheses, but simply as limitations to the area of application of the system in question. Since a relationship to reality is usually ensured by the language used in economic statements, in this case the impression is generated that a content-laden statement about reality is being made, although the system is fully immunized and thus without content. In my view that is often a source of self-deception in pure economic thought …

Defending his IS-LMism from the critique put forward by e. g. Hyman Minsky and yours truly, Paul Krugman writes:

When people like me use something like IS-LM, we’re not imagining that the IS curve is fixed in position for ever after. It’s a ceteris paribus thing, just like supply and demand.

But that is actually just another major problem — in addition to the six mentioned in my post — with the Hicksian construction! As Hans Albert so perspicaciously writes:

The law of demand is an essential component of the theory of consumer market behavior. With this law, a specific procedural pattern of price-dependent demand is not postulated, that is, a certain demand function, but only the general form that such a function ought to have. The quantity of the good demanded by the consumers is namely characterized as a monotone-decreasing function of its price.

The law appears prima facie to predicate a relatively simple and easily testable relationship and thus to have a fair amount of content. However, upon closer examination, this impression fades. As is well known, the law is usually tagged with a clause that entails numerous interpretation problems: the ceteris paribus clause … The ceteris paribus clause is not a relatively insignificant addition, which might be ignored. Rather, it can be viewed as an integral element of the law of demand itself. However, that would entail that theoreticians who interpret the clause differently de facto have different laws of demand in mind, maybe even laws that are incompatible with each other …

Bringing this to bear on our law of demand, the consequence is that … if the factors that are to be left constant remain undetermined, as not so rarely happens, then the law of demand under question is fully immunized to facts, because every case which initially appears contrary must, in the final analysis, be shown to be compatible with this law. The clause here produces something of an absolute alibi, since, for every apparently deviating behavior, some altered factors can be made responsible. This makes the statement untestable, and its informational content decreases to zero.

Jimmie “jag vet inte” Åkesson

15 September, 2014 at 11:23 | Posted in Politics & Society | 3 Comments


13 % av de som röstade i det svenska riksdagsvalet tycker tydligen att vi behöver mer av “jag vet inte” inkompetens i landets styrande organ.

Samtidigt — valresultatet speglar i betydande grad de etablerade partiernas undfallenhet att ta diskussionen om hur vårt samhälle ska hantera invandrings- och integrationsfrågorna. Att bara ställa sig vid sidan om och peka finger och låtsas som om allt är frid och fröjd är att bjuda rasister och andra mörkermän på en räkmacka.

Jag hoppas att valresultatet denna en av den svenska parlamentarismens mest nattsvarta dagar kan bli en väckarklocka.

The power from within

14 September, 2014 at 14:01 | Posted in Varia | 1 Comment


Boosting IQs and improving the future

14 September, 2014 at 10:53 | Posted in Education & School | Leave a comment


9780226100098The General Educational Development test is a seven-hour exam that allows high school dropouts to show they are equivalent to high school graduates … In a 2011 study, the GED Testing Service found that within six years of earning a GED, about 40 percent of GED recipients enroll in college — but most drop out within a year. Only about 1 percent earns a bachelor’s degree.

So this year they are launching a new, more difficult test …

The GED is a good measure of scholastic ability, but it misses a completely different set of skills that matter in high school and in life. As measured by scores on other achievement tests, GED recipients are just as smart as those who graduate but do not go on to college. But why do GED recipients drop out of high school? The GED test — and achievement tests in general — miss skills like motivation, persistence, self-esteem, time management and self-control. A growing body of evidence has shown that these types of skills can be measured and that they rival raw intelligence in determining success in the labor market and school …

Making the GED harder will not address the real problem — it still will not capture many of the skills that matter in high school and in life. Most GED preparation programs focus on test preparation, with the average student studying only 30 hours before taking the exam. It is life skills that matter, not certificates.

John Tavener

13 September, 2014 at 17:24 | Posted in Varia | Leave a comment


If a picture is worth a thousand words, music like this is worth a thousand pictures

tavenerIf thou hast shown mercy
unto man, o man,
that same mercy
shall be shown thee there;
and if on an orphan
thou hast shown compassion,
that same shall there
deliver thee from want.
If in this life
the naked thou hast clothed,
the same shall give thee
shelter there,
and sing the psalm:

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